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Behind the numbers

The reward for today's investor? Think 2.6 per cent a year Add to ...

Many stock market indicators are about as useful as cracked crystal balls. But Robert Shiller, a professor of economics at Yale University, advocates one forecasting tool that has demonstrated a modicum of predictive power over the long term.

At first glance his favoured indicator looks a lot like the familiar price-to-earnings ratio. But while the standard P/E formula divides a stock’s price by its earnings per share over the last year, Prof. Shiller’s method divides the stock’s price by its average inflation-adjusted annual earnings over the last 10 years. He calls the result a cyclically adjusted P/E ratio, or CAPE.

In contrast to a standard P/E ratio, CAPE gives you a much better picture of how prices stack up against a stock’s typical earnings power. It smoothes out temporary gains or losses. This can be vital in cases where profits jump around a lot from year to year.

Take U.S. banks as an example. They were gushing profits during the real estate boom of the mid-2000s but then lost vast sums of money in the crash of 2008. It would have been wrong to extrapolate either the boom-time profits or the recessionary red ink.

CAPE is particularly interesting when you apply it to the entire market. Prof. Shiller's CAPE for the S&P 500 is shown in the accompanying graph. The horizontal line on the graph highlights the market’s current CAPE of 22.1. As you can see, that’s quite high compared to the median level of 15.8 and suggests the market is overvalued.

You can view the same data another way. The market’s earnings yield is its earnings expressed as a percentage of its price. It’s the number of pennies of profit for every dollar you invest. You can think of the earnings yield as the mirror image of the standard P/E ratio, but earnings yields tend to be more intuitive because they are quoted in percentages just like interest rates or dividend yields.

The second graph displays Prof. Shiller’s earnings yield (again using 10-year average earnings) for the S&P 500. It shows the current earnings yield of 4.5 per cent is far below the historical median of 6.3 per cent.

Both graphs buttress the notion that the S&P 500 is expensive today. That’s good news for investors looking to sell but not so happy news for buyers. If Prof. Shiller's earnings yield suddenly moved back to its long-term median level then the market would drop by almost 30 per cent.

History suggests that long-term returns are likely to be meagre for those buying in at today’s prices. Previous periods when earnings yields were between 4 per cent and 5 per cent produced average annual returns (adjusted for inflation and including reinvested dividends) of a mere 2.6 per cent over the subsequent 10 years.

If history repeats itself, today’s investors have little margin of safety. In a market like this, it’s important for investors to keep management fees and taxes to a minimum because reducing such levies are likely to mean the difference between long-term gains and losses.

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